Inflation hedges - combating the monster under the bed

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All information is correct as at 30 April 2022 unless otherwise stated.

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Investors very broadly fall into one of two camps.

Those who want to preserve the value of their wealth by investing in a way that simply keeps pace with inflation.

And others who look to beat it through a real return – the difference between their investment returns and the rate of inflation. The recent surge in prices has blurred the lines between the two.

UK inflation’s expected to be even higher by the end of the year. Add a bleak economic outlook to that and lots of investors would bite your hand off for inflation-matching returns.

With that in mind, here’s a look at how inflation hedges work and some options for investors.

This article isn’t personal advice. If you’re not sure what’s right for you, ask for financial advice.

Inflation hedging – what is it?

You’ve probably heard of the phrase to ‘hedge your bets’. It means, to take up a position to avoid a specific outcome – usually in relation to something financial.

When hedging against inflation, you’re trying to protect the purchasing power of your money from being eroded over time.

There’s no perfect solution to combat inflation, especially at its current levels.

But the reasons for various spikes can vary over time, so it’s important to understand the drivers behind it before trying to hedge against it.

Ways to hedge against inflation

Investing to combat inflation has come a long way over the years. It’s now possible to invest in vehicles specifically designed to track inflation, called indexlinked bonds (ILBs). The UK government was the first to introduce them to help deal with the high-inflation era of the late 20th century.

ILBs keep pace with the rate of inflation by tracking inflation benchmarks, which measure the prices for goods and services, like the consumer price index (CPI) or retail price index (RPI).

They differ from traditional bonds as their value and coupon (interest) payments rise, and fall, with the rate of inflation. So, if you hold the bond from the launch date until it matures, you should receive payments in line with inflation.

Although ILBs generally do what they say on the tin, there are some things to consider.

The market for ILBs is still relatively small – it’s around $4.4 trillion compared to $100 trillion for the entire bond market. Like with other smaller markets, ILBs’ prices can quickly rise when they become the hot ticket in global markets as investors desperately dash to hedge against inflation.

Similar to other bonds, the relationship between interest rates and a bond’s price is a negative one. If interest rates rise, which they've tended to in periods of rising inflation, the bond’s price will fall. This poses a risk to the price of inflation-linked investments if interest rates rise in the future. And as with all investments, you could get back less than you invest.

Bond tracker funds – a better option for retail investors?

Investing in individual bonds can be very complex with complicated pricing structures. Some bonds, including index-linked bonds for example, often require a large initial lump-sum investment, which isn’t always suitable for retail investors.

This brings us to passive, bond index-linked tracker funds and exchange traded funds (ETFs). They invest in a basket of bonds, meaning you get to invest in lots of different bonds through one investment. The aim is to track a particular index or benchmark for inflation-linked bonds to deliver a similar return.

They make investing in index-linked bonds, and other bonds, more accessible for a retail investor and are low cost and simple to understand. Of course, like with any investment, tracker funds can work for or against you, depending on the direction of the benchmark.

Inflation hedging with gold – math or myth?

In times of uncertainty, gold has often been perceived as a safe haven for investors. This makes sense, and seems like an obvious inflation hedge, but should it be?

The perfect hedge (if there’s such a thing) should keep its value once adjusted for inflation. In other words, £1,000 30 years ago should be worth £1,000 today relatively speaking.

If you look at the relationship between gold and inflation, the correlation in price movements isn’t as strong as you’d expect. There have been periods in the past where they’ve acted in tandem, but in more recent times, the opposite is also true.

Inflation adjusted value of £1,000 gold investment

Scroll across to see the full chart.

Past performance isn't a guide to the future. Source: Refinitiv Datastream, December 1988-December 2021.

The maths show investing in gold isn’t necessarily the best option to hedge against inflation. However, it doesn’t mean investors should avoid investing in gold and other precious metals altogether. Precious metals have tended to hold their value well in uncertain times and can add some extra diversification to a portfolio.

Commodity prices can be volatile at times though. The current backdrop to the economy is fast moving and things can change quickly. This could result in short, sharp movements in commodity prices, so investing only a small amount of your overall pot in commodities is sensible.

What should investors do?

Reviewing your portfolio in light of macroeconomic events is absolutely the right thing to do. But it’s important not to overdo it. Making seismic changes to your investments based on short-term noise is rarely a recipe for success.

Holding a well-rounded, diversified range of investments, that can weather different economic and market conditions over the long term, is a good option. It’s a strategy which requires less of a ‘hands on’ approach and helps avoid trying to second guess the markets’ next move.

That said, no matter what you invest in, it’s still important to check in on your investments from time-to-time to make sure they still align with your objectives and risk appetite – once or twice a year is often useful or if your circumstances change.